A logical approach to sorting out world events. Where logic, opinion and speculation are combined to produce a reasoned, but entertaining reading experience. The unofficial hometown conservative blog of Woodridge, Il

Wednesday, July 12, 2006

A great taxation analogy and a great taxation theory

I don't usually quote the work of others as a whole, but the following seems to have gone out in an email form and a blog called Matt's Commentary posted it from the email he received. The author is unknown, but the analogy is so good it must be shown in full. Here it is:

How our Tax System works when taxes are reduced: Is it only a tax cut for the rich? Try to understand the real world economics of a tax cut. Suppose that every day, ten men go out for dinner and the bill for all comes to $100. If they paid their bill the way we pay our taxes, it would go something like this.

The first four men (the poorest) would pay nothing. Ø The fifth would pay $1 Ø The sixth would pay $3. Ø The seventh would pay $7. Ø The eighth would pay $12 Ø The ninth would pay $18. Ø The tenth man (the richest) would pay $59.

So that's what they decided to do.

The ten men ate dinner in the restaurant everyday and seemed quite happy with the arrangement, until one day the owner threw them a curve. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily meal by $20." Dinner for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes, so the first four men were unaffected. They would still eat for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his 'fair share?'

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to eat their meal. So, the restaurant owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so: Ø The fifth man, like the first four, now paid nothing (100% savings). Ø The sixth now paid $2 instead of $3 (33% savings). Ø The seventh now paid $5 instead of $7 (28% savings). Ø The eighth now paid $9 instead of $12 (25% savings). Ø The ninth now paid $14 instead of $18 (22% savings). Ø The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the men began to compare their savings.

"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"

"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar too; it's unfair that he got ten times more than me."

"That's true!" shouted the seventh man. "Why should he get $10 back when I got only $2? The wealthy get all the breaks!"

"Wait a minute" yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"

The nine men surrounded the tenth and beat him up!

The next night the tenth man didn't show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill. And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore, in fact they might start eating overseas where the atmosphere is somewhat friendlier.

**********************************************************************************That is a very powerful analogy. My thanks to the author, whoever he may be. There is another author that also deserves some respect regarding his writings on taxation. Arthur B. Laffer is the author of the Laffer Curve. Here is a link to a column he wrote devoted to his famous theory. It shows the history of the Laffer Curve, basic points of the theory, a nice picture showing the curve and some graphs showing how history has proven it to be right.

The theory points out that there are two ways a government would collect zero taxes. 1) If the tax rate were 0% 2) If the tax rate were 100%. For liberals that don't understand why money would not be flowing in if the tax rate were 100%; Hint: would you work for free? Neither would I. The theory then graphs a curve the looks like an upside down letter 'U' that points out that the same amount of revenue can come in at lower tax rates as high tax rates. Also, if the tax rate is so very high that it discourages participation more revenue can come in with lower tax rates.

Laffer describes the effects of the Kennedy tax cuts:

Using the Kennedy tax cuts of the mid-1960s as our example, it is easy to show that identical percentage tax cuts, when and where tax rates are high, are far larger than when and where tax rates are low. When President John F. Kennedy took office in 1961, the highest federal marginal tax rate was 91 percent and the lowest was 20 percent.

...

By 1965, after the Kennedy tax cuts were fully effective, the highest federal marginal tax rate had been lowered to 70 percent (a drop of 23 percent--or 21 percentage points on a base of 91 percent) and the lowest tax rate was dropped to 14 percent (30 percent lower). ... In the four years prior to the 1965 tax-rate cuts, federal government income tax revenue--adjusted for inflation--increased at an average annual rate of 2.1 percent, while total government income tax revenue (federal plus state and local) increased by 2.6 percent per year (See Table 4). In the four years following the tax cut, federal government income tax revenue increased by 8.6 percent annually and total government income tax revenue increased by 9.0 percent annually. Government income tax revenue not only increased in the years following the tax cut, it increased at a much faster rate.

Laffer also shows the clear affects of the capital gains hike and cut in '86 and '97:

As expected, increasing the capital gains tax rate from 20 percent to 28 percent in 1986 led to a surge in revenues prior to the increase ($328 billion in 1986) and a collapse in revenues after the increase took effect ($112 billion in 1991).

Reducing the capital gains tax rate from 28 percent back to 20 percent in 1997 was an unqualified success, and every claim made by the critics was wrong.

Can you say surplus? Laffer even shows how the Laffer Curve is shown at the state level and even globally. He first points out the sad but consistent saga of countries with high tax rates:

For all the brouhaha surrounding the Maastricht Treaty, budget deficits, and the like, it is revealing--to say the least--that G-12 countries with the highest tax rates have as many, if not more, fiscal problems (deficits) than the countries with lower tax rates

He then uses Ireland as an example of lowering tax rates resulting in significantly higher revenues. He even throws in a bonus when it comes to Russia by combining the topic with the "Flat Tax":

Russia has become one of the latest Eastern Bloc countries to institute a flat tax. Since the advent of the 13 percent flat personal tax (on January 1, 2001) and the 24 percent corporate tax (on January 1, 2002), the Russian economy has had amazing results. Tax revenue in Russia has increased dramatically

With all of this evidence, why are we still smacked in the face by liberals and the media with disdainful terms such as "Trickle Down Economics" and "Voodoo Economics"? The Laffer curve has proven itself again and again. Yet liberals resist it because 1) It deprives them of the power to socially re-engineer society and 2) It inevitably makes the rich richer, which seems to be a crime against humanity even if the middle class and lower class also do better.

Perhaps it is the name of the theory that people have trouble taking seriously. The fact is that the huge increases in revenue for the Federal US government, US States and other countries who have followed the curve is no "laffing" matter. The people of this country need to understand taxation. Taxation is such a lynch-pin of socialist thinking that to the hard leftists it is non-negotiable. If they admit the dramatic results of the Laffer Curve Theory put into practice, they lose power and influence. That cannot be tolerated by the champions of tolerance.

14 Comments:

and if they cut back most of what washington does, there'd be even more tax cuts, making the rich even more rich. yeehaw, I say.

good post.

did you read about warren buffett giving away thirty billion to bill gates' foundation? after he did it, he said something to the effect of desiring laws to Prevent people from getting as rich as he did. WHAT? crazy old man...

So now libs want a glass ceiling for the rich? What if its a rich woman like Oprah Winfrey? She spends her life breaking the glass ceiling for woman only to get another glass ceiling because she is rich?

Your right - Warren Buffet is a crazy old man. What is it with these crazy old liberal men like Buffet, Carter and Ted Turner? They can't stop embarrassing themselves.

Of course I recently read something said by William F. Buckley that made me think it might simply be an old man syndrome rather than restricted to libs.

I'll apologize up front for not having the time or energy (or the stomach, really) to take on your numbers - if they point toward the Laffer curve as incontrovertible fact they are cooked numbers, plain and simple.

The Laffer curve is not widely accepted anywhere outside of certain political adherents. That thing you perceive as a smack in the face is where what you've been led to believe smacks up against reality. Its not liberals doing it to you, you're doing it to yourself. Laffer is ultimately a faith-based economic theory. Or, if you prefer, junk economics. There are many, many persuasive arguments against Laffer. You and I and the crew could spend the next couple days lobbing these arguments at each other, peppered with numbers. I'd rather not go through that exercise. Here's one, though, just to substantiate my point.

This year the Congressional Budget Office dismissed without reservation the whole notion of the Laffer Curve effect paying for tax cuts at current tax rates. Here's a concise paraphrase from Wikipedia:Even in the paper's most generous scenario, only 28% of lost tax revenue is recouped over a 10-year period after a 10% tax-rate cut. The paper points out that these shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra $200 billion in interest over the decade covered by his analysis. The 10% tax cut would result in a 1% increase in gross national product.

paw, your rejection of the Laffer curve is duly noted. I understand that to fully discuss would take more time and energy than either of us have . The end result would be that we still disagree with each other.

This is a big and ambitious post on your part, and I recognize the effort and thought that went into it, and have to say you're expressing yourself quite well and in an entertaining fashion - nicely done, from that perspective.

I'm curious if the CBO is considered a credible source among your crowd.

paw, thanks for the nice words. As for the CBO, I personally don't get a warm and fuzzy feeling when I hear that name. I don't know for sure but I would guess my crowd has more of a negative feeling toward them.

Americans from both sides of the aisle can't even trust the first layer of government. Once you start peeling back layers like an onion you really start to cry. I would consider the CBO a few layers in.

I might trust to some degree any raw numbers they could give. Once they start giving an opinion of what the numbers mean, I don body armor, a surgical face mask, eye protection, a cross and a string of garlic.

Laffer curve or no Laffer curve, it doesn't take a genious to figure out that the federal government has no need to take more than the 35 percent of my paycheck that they already take. I think one reason many in this country are so willing to vote for politicians that they know are going to raise their taxes is that people, for the most part, never see that money. If everyone had to write a check each year to the government in order to pay their taxes, I think we'd hear an outcry like we've never heard before. Everyone moans about paying over 3 dollars a gallon for gas - imagine if we all had to sit down each year and write out a check for thirty thousand dollars in taxes, instead of it being automatically withdrawn. I don't give a rip about government revenues. I care about keeping the money I earned. If the government needs more money, the answer is not to take more of mine. The answer is to stop spending!

That’s interesting. But the illustration is, in my opinion, flawed in several ways.

First and foremost is the assumption that the first 4 of the 10 pay nothing at all for their dinner, which is meant to say that they do not pay taxes. But in fact, they do pay plenty of taxes. For example the payroll tax, sales taxes, property taxes, gas taxes, etc..

You may argue that they are less likely to pay property taxes since they may not be property owners, but in fact property taxes are also paid through rents as they are passed through by owners. As well, it can be argued that the sales tax is a lot more of a burden on the 4 poor persons than it is on the 10th, as the 4 poor persons are likely to spend their entire income, thus being taxed on 100% of it, while wealthier people would only spend a portion, and invest the rest, thus being taxed on only that portion that they spend. For example, someone who makes $20,000 a year and spends $16,000 on taxable items (with a 5% sales tax) would have an effective rate of 4% tax, while someone who makes $500,000 a year and spends $100,000 on taxable items would have an effective rate of 1%, or 4 times less.

As for the payroll tax, this is why it's relevant: a person who earns $20,000 per year pays 6.4% in payroll taxes and his employer pays the same. The person who earns $500,000 per year pays only about 1% in payroll taxes (and the employer pays the same). During the fiscal year just completed, over 100 billion dollars from the payroll taxes were used for the general budget. This was necessary, in great part, because of the Bush tax cuts. During the past 20 years, approximately 1.7 trillion dollars from the payroll taxes have been used for general budget purposes. If that's not paying taxes, what is?

The second flaw is the assumption that the 10 men are eating the same dinner. They are not. The first 4 are eating some sandwiches with a soda, while the last 1 is eating at the Palm, with a $2,500 bottle of Chateau Margaux. It is important in terms of what in economics is called the “utility of income”. Without going to great lengths to describe the concept, suffice to say that it states that a dollar is worth more to a poor man than to a rich man. For example, the $4 used to pay a gallon of milk has a lot of “utility” to the poor man, while it has almost no “utility” whatsoever to the wealthy man.

Finally, it ignores completely the fact that a tax cut, when not matched equally by a reduction in expenses, is not a tax cut at all, but a loan that will need to be repaid later, some of it by the same 10 men in about the same proportions that they originally were taxed for, some of it by their children. While one may argue that by generating economic activity the tax cut (the loan) will have the effect of increasing the tax revenue, and thus make easier the repayment, the fact remains that that loan will have to be repaid in its entirety. So it is not really a tax cut. Just borrowing. There is no magic windfall.

In addition, they will also need to add interest to that debt, and pay the effects that the borrowing will have had on the price of the dollar (already fallen by 30% since tax cuts went into effect, as large deficits reduce the confidence of international markets in the future of the economy). For that last payment, it is likely to be more difficult for the poor man, as he used to shop Kmart for products from Taiwan, which are now more expensive (in theory by 30%, but less in practice).

Large deficits, because they generate higher inflation and higher interest rates, are also more likely to affect the 4 poor men more in the sense that they are likely the ones who pay interest when they borrow money, while the wealthier will receive the benefit of higher interest rates on their savings.

So saying that the “first four continued to eat for free”, suggesting that the change in policy did not affect them at all, is, I think, deceptive.

Anyway, this is not meant as an endorsement or an opposition to anyone’s policy, just a critique of this particular illustration, which I find at best simplistic, and at worst misleading.

After consideration I think you took too many liberties with the analogy. In the analogy the diners represent the wage earners. The payment for the meal represents taxes and the meal represents what is garnered from those taxes.

Since when going to a restaurant you only pay one single source, this analogy can only deal with one kind of tax. In fact tax reduction usually only deals with one kind of tax event. If in an analogy in a parallel universe this group wants to go out to a show afterward, then all of those taxes you mentioned might have some relevancy.

As for the meal, you took the most liberty. The meal represents what is given back in return for the payment. The government provides various services such as defense, education, etc. The meal in the analogy does not represent the lifestyles of the patrons - meager or lavish. The concept that the rich are rich because of government does not make any sense.

The comments on the loan go way beyond the analogy. The analogy only deals with revenue, not expenditures. We are not in the analogy concerned with what the restaurant owner does with the money he collects.

Since revenues go up during these tax cuts (as discussed in the Laffer Curve section). So the concept of the loan has nothing to do with taxation. It is 100% on the decisions to spend.

I think from your comments that your money does not really belong to you, but to the government. What they then decide to bestow upon you is up to their whims. No, the money I earn is mine before I start paying my bills. The government tax is just one of those bills.

Finally, rarely is there a perfect analogy. I think this is a good one, but not perfect. The analogy is to lead people to think, not make a case.